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Put simply, foreign exchange settlement risk is the risk that you do not receive the currency you bought having already paid away the currency you sold. It is the result of trades requiring settlement in different time zones, trades requiring payment in different payment systems, different rules on finality in different payment systems and delays in reconciliation. The regulators have stated that settlement risk can last for a minimum of three days for each transaction being settled.
Since 1974, the volumes of foreign exchange trades have grown enormously. In 1989, the daily value of foreign exchange trades for banks, financial institutions and customers was US$ 1.6 trillion; by 1998 this was US$4.5 trillion, a figure where it posed significant systemic risk. The regulators commissioned the Bank for International Settlements to produce a number of reports seeking to address this risk, with the Allsopp Report (1996) recommending that industry groups be formed to seek potential solutions. The report gave the banking industry two years to propose a solution or face the possibility of capital requirements on the value of settlement exposures.
Immediately prior to this, the Group of Twenty (G20) was formed by the major foreign exchange trading banks in 1995 to develop a private sector solution to the problem of settlement risk.
The model selected by the G20 as the best solution was Continu- ous Linked Settlement (CLSTM). This is a payment-versus-payment model where a final transfer in one currency only happens if, and only if, a final transfer in the other currency also takes place, simultaneously eliminating, by its very nature, settlement risk. The G20 proposed the establishment of a CLS Bank as a co-operatively owned industry infrastructure to provide settlement services.
So what does Continuous Linked Settlement do? Whilst the CLS process settles all FX deals across the accounts of the CLS Bank at their gross ticket value, the cash requirements are calculated as the net of all the bought and sold contracts for each currency. Thus the system allows the management of the required level of liquidity throughout the settlement system. It poses a new challenge for Settlement Banks because it needs liquidity in large tranches at particular and demanding times of day.
From a situation where a number of vertical silo systems (domestic settlement systems and domestic security systems) had tried and tested methods of handling any problems, we have now entered a brave new world where CLS is the first major infrastructure which connects systems around the globe. And while it addresses settlement risk, it creates a whole raft of new liquidity management issues of which very few organisations have a real understanding.
The paying in of US Dollars starts at 07.00 CET (01.00 EST) and the final payment from the CLS Bank is at 12.00 CET (06.00 EST). Similarly, Japanese Yen are paid in from 07.00 CET (15.00 JST) and the final payment is 12.00 CET (20.00 JST). These demands for time critical payments require the development of robust, new functionality by cash nostro service providers. In addition, new processes will be required to be developed within the banking community to manage the changing demands for liquidity. These include: intraday markets for funds; global pooling of collateral; increased mobility of collateral; new brokerage services; arbitrage between CLS and non-CLS funds; and 'white boards' to indicate holders of counter positions that can be traded out.
Continuous Linked Settlement will affect existing service providers by leading to a decrease in the number of settlement payments for FX contracts and cutting out settlement and operational risk because there are fewer transactions. More importantly, it will also decrease the intra-day overdrawn positions on customers' nostro accounts making much lower limits possible, subject to the customer's credit assessment.
Currently, to be a nostro cash service supplier is essentially straightforward requiring communications links to SWIFT, a payment application, an account with the relevant Central Bank and access to the RTGS system. Where today hundreds of banks around the globe provide cash nostro services in individual currencies, in the world of CLS, few banks are likely to have the technology and market presence to provide CLS services to non-shareholders in the CLS Bank. And as the volume of trades settled by CLS increases, the speed of migration of settlement business to these banks will quicken.
Because we have integrated CLS with our Global Treasury Settlement System, we have removed the need for manual intervention, and, we believe, indicated the extent to which CLS is a perfect fit for Barclays and Barclays is a perfect fit for CLS. We believe that there are few banks which are in the same state of development and readiness for CLS as ourselves and this is why we now want to tell you about our CLS Third party service.
Barclays CLS Third Party
One of the most attractive aspects of our service however, is that we pay out currency long positions before the completion of the CLS cycle, within an agreed CLS multicurrency intra-day exposure limit, on receipt of your SWIFT MT202 instruction. Obviously, this is reliant on the customer's limit.
It allows you to use identical messaging structures to those of the CLS Bank Settlement Members, the adoption of industry protocols and SWIFT standards by T-copy of MT300 foreign exchange confirmation messages.
Trade Capture using Barclays'
CLS Third Party service
Real time data allows you to manage your exposure at any time. At the beginning of every settlement day, CLS Bank provides us with a schedule that reflects all of the movements to be processed that day. We reconcile the statement against our own records and pay the required funding demands of CLS Bank in each currency. As soon as we have agreed the CLS Bank schedule, we send you a SWIFT MT 970 netting statement of all your contracts we are about to settle. And we also provide you with a SWIFT MT971 netting balance report (equivalent to a pay-in schedule) allowing you to pay away your long positions and fund your short positions over your CLS settlement accounts held with Barclays.
Using SWIFT FIN messages, we will inform you of (a) the changed status of your trades immediately if an individual transaction warrants attention and (b) complete details of all your deals held by Barclays together with their status. In addition, our web browser will allow you to check status in real time.
The bank believes that this level of transparency will enable clients to exercise the tight control they require over foreign exchange transactions while removing as much administration from you as possible.
The bank then provides a fully automated straight-through processing service. This allows us to provide you with the benefits of speed, automation, no manual intervention or errors and a resilient system sharing all the same processes and security as we rely on ourselves.
Barclays has emulated some of the limit structures used by the CLS Bank. Thus we calculate a currency short position limit and aggregate short position limit; additionally, we set a volatility limit and CLS multicurrency intraday exposure limit. These will allow you a clear understanding of your exposure and risk
Finally, Barclays has built a range of options to allow us to tie the basis of charging closely to your needs. If you are a financial institution trading in foreign currencies, you should speak to Barclays to see how, together, we can use continuous linked settlement to meet your needs.
But the CLS story does not end here. Ongoing development is taking place to increase functionality and flexibility and to address other needs of institutions trading foreign exchange.
The services that will be offered by CLS are part of an overall industry drive to effectively manage, control and reduce settlement and operational risk. It is not the only industry initiative to tackle these problems. CLS is initially developed for the FX market whilst central bank money DvP (delivery v payment) systems are being rolled out for the securities market, a prime example being CREST DvP which is to be launched in late November 2001 in the UK.
Together these settlement and operational risk reduction facilitators create other challenges for financial institutions. They are intraday liquidity demand and the risk of cross system contagion. These sound like serious risks and indeed they are. However CLS Settlement Member institutions have been working together to design and deliver liquidity management tools for the launch of CLS.
Firstly the so called Inside/ Outside swap will be available for CLS Settlement Members to use. This will be an intraday FX swap and will be used by Settlement Members to "trade down" spikes in their expected pay in schedules with Settlement Members with opposite positions in CLS currencies. This will have the effect of smoothing out potential large pay-in/pay-out positions in CLS prior to settlement commencing on a particular day and consequentially significantly reducing the risk of liquidity logjams.
A similar group of international banks is also looking at creating a global liquidity bridge mechanism. This has become known as the common cash/collateral pool (CCCP). This simple concept requires an immense amount of co-operation between the public and private sector Institutions in various countries to bring it to reality. Basically it uses cash or collateral deposited/ pledged or repoed with one central bank to get intraday liquidity from another central bank; for example a bank in the UK could use sterling assets with the Bank of England to obtain liquidity from the Federal Reserve. This concept is in the discussion stage but the CCCP has been adopted by the New York Payments Risk Committee as a study case.
Such liquidity management tools if supported by the industry will go a long way to ensuring the smooth launch and running of CLS and DvP over the coming months and years.
CLS is not expected to provide FX services alone in the longer term. It provides a special platform for the global industry as the only service provider linked simultaneously to a number of national RTGS systems. Initially it offers seven currencies with the prospect of six more after a successful launch. This platform is a unique offering from CLS and industry pressures will no doubt emerge to use the capabilities of this prize asset. Delivering the cross currency, cross border payment leg of DvP is a very obvious candidate for this.
A combination of this special platform, practical liquidity management tools and robust contingency will ensure that CLS does not stop at FX settlement alone. Once the service has been successfully launched in the FX market, other advances will follow.
So to summarise, Barclays CLS Third Party service provides you, the customer, with the full risk reduction benefits of the service offered by CLS Bank - the same level of risk reduction which Barclays enjoys as a full member of CLS Bank.
We will put in place a service level agreement and can assure you of competitive fees. And so long as it remains UK market practice, we will not levy any intra-day overdraft or liquidity charges.
Finally, as has been said earlier, taking up our service means minimum change to your existing internal processes and no new hardware or software requirements.
Barclays believes that the Continuous Linked Settlement payment-versus-payment model addresses the challenge posed by foreign exchange settlement risk. However, we also believe that Barclays CLS Third Party service offers a combination of straightforward system functionality with access to a powerful international payment system which will be irresistible to many financial institutions. Talk to us about CLS. See how we can make a difference for you.
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